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Buying a little stock at a time cuts your risk

By Bryan BorzykowskiSpecial to the Star

Thu., Oct. 20, 2011

When Mark Werner changed his investment strategy in 2001, he couldn’t have known that his new way to save would pay off a decade later.

Back then, Werner was putting a lump sum of cash in his RRSPs right before the deadline. After he quit his job to become a self-employed IT consultant, he needed to start managing his cash-flow better and began investing a fixed amount of money every month.

That strategy, called dollar-cost averaging, is coming in handy now, when it’s impossible to predict which way the markets will move.

“This strategy flattens out the peaks and valleys,” says Werner. “So when the markets dropped, I didn’t have to do anything differently.”

What is dollar-cost averaging?

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This strategy, called DCA for short, is for investors who can’t stomach the volatility of the markets.

People put a set amount of money in their investments on the same day each month, usually through an automatic withdrawal. This way, people avoid timing the markets and they don’t have to worry about the price of an investment.

“It’s difficult at the best of times to know the price of a security,” says Cynthia Kett, a principal at Toronto’s Stewart & Kett Financial Advisors Inc. “And today it’s totally unpredictable. So, in a way, with dollar-cost averaging, you resign yourself to the fact that good enough is good enough as opposed to aiming for the highs and buying on the lows.”

How does it work?

Usually, people invest a set amount of money each month.

Stephanie Holmes-Winton, a Nova Scotia-based financial adviser and author, says that monthly payments just make good sense for financial planning.

“When I’m managing cash-flow, I’m basing things on the average expense per month,” she says. “And once a month is a timeframe the client can prepare for.”

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The best way to use dollar-cost averaging is to set up automatic withdrawals. Every month, $750 is automatically sent from Werner’s account to his adviser, who splits the cash up into three investments. The same amount of money goes into each mutual fund.

He revisits his asset-allocation annually to see if he should buy something new or shift more money into a specific fund.

If you do have a lump sum, but still want to invest this way, you can put it into a DCA fund. Every month, the financial company transfers a set amount of money from that fund into an investment.

To determine how much you should invest each month, you should review your cash-flow needs and see what fits into the rest of your expenses, Kett suggests. If you have some money set aside to invest, just divide it by 12.

What are the advantages?

There are two big advantages to dollar-cost averaging. The first is that you are forcing yourself to buy. In troubled markets, such as we’re experiencing today, investors will end up buying more stocks or funds because prices are low. So they can take advantage of the dips.

If the market rises, investors will end up buying less stock, because their money won’t go as far, but the idea is that it’ll balance out in the end. Of course, the market has been down for a while, so use DCA today and you should end up with a good chunk of equities.

The second, and, perhaps, most important, benefit to DCA is it takes the psychology out of investing. There have been studies that show investing a lump sum will actually make you a bit more money in the long run, but not having to sweat over rising and falling markets is often worth a slightly lower long-term return to many investors.

“Investing is as much about psychology as it is about math,” says Chris Paterson, a consultant with Hahn Investment Stewards. “So whether you use this strategy really depends on risk tolerance and where your money is going.”

“I’m pretty sure psychology trumps almost everything mathematical,” adds Holmes-Winton. “If someone puts money away every month, they always feel like the are making progress and they react less intensely to market volatility.”

Taking a closer look

The main drawback to dollar-cost averaging is that investors don’t get to take advantage of the peaks and troughs.

Some people might want to hold on to their cash and load up on stock when the market is low. You can also sell using dollar-cost averaging: You sell the same amount of stock every month.

If you use this strategy when the market’s falling, you’ll end up selling low, not high.

Since dollar-cost averaging takes the volatility out of investing, Paterson suggests using it only with risky buys. If investors want to buy one stock, the strategy makes a lot of sense. If someone has a diversified portfolio that doesn’t fluctuate much, the strategy is less advantageous.

But, for many, dollar-cost averaging forces people to save and that’s a good thing.

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